Trading with brokers. Foreign exchange brokers, unlike equity brokers, do not take positions for themselves; they only service banks. Their roles are to bring together buyers and sellers in the market, to optimize the price they show to their customers and quickly, accurately, and faithfully executing the traders' orders.
The majority of the foreign exchange brokers execute business via phone using an open box system
— a microphone in front of the broker that continuously transmits everything he or she says on the direct phone lines to the speaker boxes in the banks. This way, all banks can hear all the deals being executed.
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Because of the open box system used by brokers, a trader is able to hear all prices quoted; whether the bid was hit or the offer taken; and the following price. What the trader will not be able to hear is the amounts of particular bids and offers and the names of the banks showing the prices. Prices are anonymous. The anonymity of the banks that are trading in the market ensures the market's efficiency, as all banks have a fair chance to trade.
Sometimes brokers charge a commission that is paid equally by the buyer and the seller. The fees
are negotiated on an individual basis by the bank and the brokerage firm.
Brokers show their customers the prices made by other customers either two-way ( bid and offer) prices or one way ( bid or offer) prices from his or her customers. Traders show different prices because they
"read" the market differently; they have different expectations and different interests. A broker who has more than one price on one or both sides will automatically optimize the price. In other words, the broker will always show the highest bid and the lowest offer. Therefore, the market has access to an optimal spread possible. Fundamental and technical analyses are used for forecasting the future direction of the currency. A trader might test the market by hitting a bid for a small amount to see if there is any reaction.
Another advantage of the brokers' market is that brokers might provide a broader selection of banks to their customers. Some European and Asian banks have overnight desks so their orders are usually placed with brokers who can deal with the American banks, adding to the liquidity of the market.
Direct dealing. Direct dealing is based on trading reciprocity. A market maker—the bank making or quoting a price — expects the bank that is calling to reciprocate with respect to making a price when called upon. Direct dealing provides more trading discretion, as compared to dealing in the brokers'
market. Sometimes traders take advantage of this characteristic.
Direct dealing used to be conducted mostly on the phone. Phone dealing was error-prone and slow.
Dealing errors were difficult to prove and even more difficult to settle. Direct dealing was forever changed in the mid-1980s, by the introduction of dealing systems.
Dealing systems are on-line computers that link the contributing banks around the world on a
one-on-one basis. The performance of dealing systems is characterized by speed, reliability, and safety.
Dealing systems are continuously being improved in order to offer maximum support to the dealer's main function: trading. The software is rather reliable in picking up the big figure of the exchange rates and the standard value dates. In addition, it is extremely precise and fast in contacting other parties, switching among conversations, and accessing the database. The trader is in continuous visual contact with the
information exchanged on the monitor. It is easier to see than hear this information, especially when switching among conversations.
Most banks use a combination of brokers and direct dealing systems. Both approaches reach the
same banks, but not the same parties, because corporations, for instance, cannot deal in the brokers'
market. Traders develop personal relationships with both brokers and traders in the markets, but select their trading medium based on price quality, not on personal feelings. The market share between dealing systems and brokers fluctuates based on market conditions. Fast market conditions are beneficial to dealing systems, whereas regular market conditions are more beneficial to brokers.
Matching systems. Unlike dealing systems, on which trading is not anonymous and is conducted on a one-on-one basis, matching systems are anonymous and individual traders deal against the rest of the market, similar to dealing in the brokers' market. However, unlike the brokers' market, there are no
individuals to bring the prices to the market, and liquidity may be limited at times. Matching systems are well-suited for trading smaller amounts as well.
The dealing systems' characteristics of speed, reliability, and safety are replicated in the
matching systems. In addition, credit lines are automatically managed by the systems. Traders input the total credit line for each counterparty. When the credit line has been reached, the system automatically
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disallows dealing with the particular party by displaying credit restrictions, or shows the trader only the price made by banks that have open lines of credit. As soon as the credit line is restored, the system allows the bank to deal again. In the inter-bank market, traders deal directly with dealing systems,
matching systems, and brokers in a complementary fashion.
3. Fundamental analysis by trading on Forex
Two types of analysis are used for the market movements forecasting: fundamental, and technical
(the chart study of past behavior of currencies prices). The fundamental one focuses on the theoretical models of exchange rate determination and on the major economic factors and their likelihood of affecting the foreign exchange rates.
3.1. Theories of exchange rate determination
Purchasing power parity. Purchasing power parity states that the price of a good in one country should equal the price of the same good in another country, exchanged at the current rate—the law of one price. There are two versions of the purchasing power parity theory: the absolute version and the relative version. Under the absolute version, the exchange rate simply equals the ratio of the two countries'
general price levels, which is the weighted average of all goods produced in a country. However, this version works only if it is possible to find two countries, which produce or consume the same goods.
Moreover, the absolute version assumes that transportation costs and trade barriers are insignificant. In reality, transportation costs are significant and dissimilar around the world. Trade barriers are still alive and well, sometimes obvious and sometimes hidden, and they influence costs and goods distribution.
Finally, this version disregards the importance of brand names. For example, cars are chosen not
only based on the best price for the same type of car, but also on the basis of the name ("You are what you drive").
Under the PPP relative version, the percentage change in the exchange rate from a given base
period must equal the difference between the percentage change in the domestic price level and the
percentage change in the foreign price level. The relative version of the PPP is also not free of problems: it is difficult or arbitrary to define the base period, trade restrictions remain a real and thorny issue, just as with the absolute version, different price index weighting and the inclusion of different products in the indexes make the comparison difficult and in the long term, countries' internal price ratios may change, causing the exchange rate to move away from the relative PPP.
In conclusion, the spot exchange rate moves independently of relative domestic and foreign prices.
In the short run, the exchange rate is influenced by financial and not by commodity market conditions.
Theory of elasticities. The theory of elasticities holds that the exchange rate is simply the price of foreign exchange that maintains the balance of payments in equilibrium. In other words, the degree to which the exchange rate responds to a change in the trade balance depends entirely on the elasticity of demand to a change in price. For instance, if the imports of country A are strong, then the trade balance is weak. Consequently, the exchange rate rises, leading to the growth of country A's exports, and triggers in turn a rise in its domestic income, along with a decrease in its foreign income. Whereas a rise in the domestic income (in country A) will trigger an increase in the domestic consumption of both domestic and foreign goods and, therefore, more demand for foreign currencies, a decrease in the foreign income (in country B) will trigger a decrease in the domestic consumption of both country B's domestic and foreign goods, and therefore less demand for its own currency.
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The elasticities approach is not problem-free because in the short term the exchange rate is more
inelastic than it is in the long term and additional exchange rate variables arise continuously, changing the rules of the game.
Modern monetary theories on short-term exchange rate volatility. The modern monetary
theories on short-term exchange rate volatility take into consideration the short-term capital markets'
role and the long-term impact of the commodity markets on foreign exchange. These theories hold that the divergence between the exchange rate and the purchasing power parity is due to the supply and demand
for financial assets and the international capability.
One of the modern monetary theories states that exchange rate volatility is triggered by a one-
time domestic money supply increase, because this is assumed to raise expectations of higher future
monetary growth.
The purchasing power parity theory is extended to include the capital markets. If, in both countries
whose currencies are exchanged, the demand for money is determined by the level of domestic income and domestic interest rates, then a higher income increases demand for transactions balances while a higher interest rate increases the opportunity cost of holding money, reducing the demand for money.
Under a second approach, the exchange rate adjusts instantaneously to maintain continuous interest
rate parity, but only in the long run to maintain PPP. Volatility occurs because the commodity markets adjust more slowly than the financial markets. This version is known as the dynamic monetary approach.
Synthesis of traditional and modern monetary views. In order to better suit the previous theories to the realities of the market, some of the more stringent conditions were adjusted into a synthesis of the traditional and modern monetary theories.
A short-term capital outflow induced by a monetary shock creates a payments imbalance that
requires an exchange rate change to maintain balance of payments equilibrium. Speculative forces,
commodity markets disturbances, and the existences of short-term capital mobility trigger the exchange rate volatility. The degree of change in the exchange rate is a function of consumers' elasticity of demand.
Because the financial markets adjust faster than the commodities markets, the exchange rate tends to be affected in the short term by capital market changes, and in the long term by commodities changes.
3.2. Economic for the fundamental analysis
For the fundamental analysis on Forex, just as on any goods market, traders use the
information from analytical reviews of specialists published in newspapers as well as charts and
tables of many numerical indicators serving this purpose. All fundamental indicators generally.
released on a monthly basis, except of the Gross Domestic Product and the Employment Cost Index, which are released quarterly (See below).
All economic indicators are released in pairs. The first number reflects the latest period. The
second number is the revised figure for the month prior to the latest period. For instance, in July, economic data is released for the month of June, the latest period. In addition, the release includes the revision of the same economic indicator figure for the month of May. The reason for the revision is that the
department in charge of the economic statistics compilation is in a better position to gather more information in a month's time. This feature is important for traders. If the figure for an economic indicator is better than expected by 0.4% for the past month, but the previous month's number is revised lower by 0.4%, then
traders can draw a justified conclusion about the economy situation.
Economic indicators are released at different times. In the United States, economic data is
generally released at 8:30 and 10 AM ET. It is important to remember that the most significant data for foreign exchange is released at 8:30 AM ET. In order to allow time for last-minute adjustments, the United States currency futures markets open at 8:20 AM ET.
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Sources of information. Information on upcoming economic indicators is published in all leading newspapers, such as the Wall Street Journal, the Financial Times, and the New York Times; and business magazines, such as Business Week. More often than not, traders use the monitor sources—
Bridge Information Systems, Reuters, or Bloomberg — to gather information both from news publications and from the sources' own up-to-date information.
Separate groups of fundamental indicators are considered below in accordance with a
generally accepted classification.